Chapter 8 Valuation

Chapter 8 Valuation distribute Learning Objectivesor • To know the nuances of the concept of “value” • To understand the valuation process • To be able to do a valuationpost, Case: Franks copy,Brothers LLC Robert Franks was worried. Since his brother Bill died, Robert’s whole life had been turned upside down. He had lost his brother and trustednot business partner, and now there were problems with Bill’s widow, Marta. The business had been doing fine, but now Marta was faced Dowith a potentially high and almost impossible-to-pay estate tax assessment. Because of this potential tax bill and her desire to get as much money as possible, Marta was demanding that Robert buy her out of the business. And she was asking a very high price, a much higher price than Robert had money to pay. 139 Copyright ©2015 by SAGE Publications, Inc. This work may not be reproduced or distributed in any form or by any means without express written permission of the publisher. 140——Entrepreneurial Finance Seventeen years ago, Robert and Bill had gone to an attorney to have a “buy-sell” agreement written. The agreement specified that should one of them die or become incapacitated, then the remaining brother would have the option to buy out the interests of the brother who had died or who was incapacitated. If a buyout did not take place within 1 year, then the survivors had the right to sell their share of the business on the open market. There were 6 months left until the option expired. The root of the present problem was that the price that was to be used in the buyout was to be determined by an appraisal of the business. Marta hired an appraiser who had determined that the price should be higher than anything Robert had felt was reason- able. This high value was also the cause of the high estate tax estimate. Lately, Marta was becoming more strident and vocal about her desire to be bought out, and the situation wasdistribute beginning to cause general friction in the family as members of the family began to take sides in the matter. When Robert talked with Marta’s appraiseror about how the firm’s value was determined, Robert was told that the appraiser had looked at analogous public firms with similar growth rates to Franks Brothers and then applied a similar price to equity, price to book, and price to sales ratio to Franks Brothers LLC to determine the firm’s value without makingpost, any adjustments, such as the fact that Franks Brothers was privately held. Seventeen years ago, when the buyout agreement was signed, the business had been struggling, but now it was growing rapidly. This rapid growth has been consuming more and more working capital. Since Bill’scopy, death, Robert needed to pledge most of his personal assets to securing the working capital loan from the bank to finance this rapid growth. This loan also prevented the company from borrowingnot additional funds to pay Marta. To complicate matters more, Bill owned only 45% of the business at the time of his death. Several years prior to his death, Bill had Dogiven shares representing 5% of the company to his alma mater. So the share of the business that Marta had to sell was not a controlling interest. To further complicate the situation, a longtime employee of the company had felt that one of her supervisors had acted improperly toward her; she had quit and was suing the firm for Copyright ©2015 by SAGE Publications, Inc. This work may not be reproduced or distributed in any form or by any means without express written permission of the publisher. CHAPTER 8 Valuation——141 sexual discrimination and harassment. If the company lost the suit, the damages could be substantial. Robert decided to become more knowledgeable about the process involved in valuing nonpublic businesses. He realized there were many aspects to the Franks Brothers situation that were unique: 1. The company was closely held, and Bill held the controlling interest. Marta was selling shares representing a minority interest. 2. The company did not trade in the public market and had no established market price to determine the firm’s value. 3. The company was growing rapidly and was highly leveraged. 4. The employee lawsuit represented a substantialdistribute contingent liability. 5. Any appraisal would need to hold upor in court, as there could be legal actions with respect to Marta and the employee suit. Robert now knew that establishing the value of an entrepreneurial venture is complicatedpost, and definitely not straightforward. He was resolved to learn about valuing entrepreneurial privately held ventures. aluing any riskycopy, asset is not always as straightforward as it may seem. If Vno value can be established in a public market, then the problem of establishing value becomes more difficult. If there is no value that exists in a public market, thennot what does the concept of value entail? Is the value what two parties agree to? Is it what the accounting records of the firm indicate? Is value what an expert says it is? If valuing were as simple as providing answers to Dothese questions, then parties would rarely disagree on what it is. The most basic concept of value is that any risky asset is worth the present value of all expected future cash flows discounted back to the present at an appropriate risk-adjusted required rate of return. If we accept this concept, then two problems arise: What are those future cash flows (how certain are they, at what intervals do they occur, and how long do they last), and what is the appropriate risk-adjusted rate of return? Copyright ©2015 by SAGE Publications, Inc. This work may not be reproduced or distributed in any form or by any means without express written permission of the publisher. 142——Entrepreneurial Finance When valuing entrepreneurial privately held ventures, the inherent cash generation of the firm is important, but so are other features of the firm, such as technology, growth, management, industry sector, and strategy. Research into exit strategies for firms financed by private equity sources indicates that 74% of the exits are implemented through those firms being acquired by strategic buyers (i.e., another firm or investor with interest in the industry); about 20% of the exits are implemented through initial public offerings (IPOs) in the public market, and the remaining are through some specialized vehicle like a management buyout, Employee Stock Ownership Plan, trade sale, or a transfer to a family member (Dwivedi et al., 2012). Since most entrepreneurial ventures are not ultimately sold in public market transactions, the concept of value and the constituents of value become even more key to the entrepreneur’s understanding of the potential outcomes—a sale to another firm in the industry, a sale to another businessper- son, a sale to a private equity firm, a conveyance to a familydistribute member, or a sale through an initial public offering. Given these outcomes, except for the last one, a range of concepts is needed that describes value under different environments.or Each of these concepts exists with the sole purpose of fulfilling a particular role in deter- mining the standards that should be applied to the valuation process under different circumstances. Chart 8.1 presents a schematic representation of the material covered in this chapter. post, Chart 8.1 Schematic of Chapter 8 copy, Valuation not Concepts of The Valuation Assembling Do Value Process a Valuation Concepts of Value Value is generated in many ways; each form may be a composite of one or more sources of value—for example, cash flow, intellectual property, tax impacts, enterprise control, liquidity, or marketability. All or any portion of Copyright ©2015 by SAGE Publications, Inc. This work may not be reproduced or distributed in any form or by any means without express written permission of the publisher. CHAPTER 8 Valuation——143 these sources of value may be relevant at a particular point in time or under a particular circumstance. Depending on the circumstances and context in which the question is being asked, value may take the forms identified below. According to Zukin (1990), the different concepts of value are situational and understood based on the context from which they arise: Value cannot be used in isolation. The meaning of value can change, depending upon the context within which the term is used. Lack of clarity concerning these concepts often leads to material disagreements in specific valuations. Therefore, the term should never be used unless defined. (pp. 2–3) The idea that there can be a number of interpretations of value is a critical first step in understanding valuation in general. Each valuation performed is situational and case specific, and each case drives the person doing the valuation to rely on different types of information, to emphasize different value streams, to consider different timetables over which thosedistribute benefits occur, and to choose appropriate techniques to employ when considering the stream of benefits. In litigation, arbitration, tax appraisals,or and face-to-face negotia- tions, the relevance of any specific estimate of value is highly dependent on the context and the audience. Ultimately, context drives the choice of valuation technique, type of data relied on, and certainty of conclusion. The American Society of Appraisers (ASA), various courts, government agencies (e.g., Internal Revenue Service [IRS]),post, and most authors in the field agree that seven types of value are routinely considered. Furthermore, these different valuation scenarios rely on different techniques and emphasize different sources of information and different aspects of value.

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